Regulating Bankers’ Pay

The program on corporate governance just issued our discussion paper, Regulating Bankers’ Pay, and it is available here.

The paper seeks to contribute to understanding the role of executive compensation as a possible cause of the current financial crisis, to assessing current legislative and regulatory attempts to discourage bank executives from taking excessive risks, and to identifying how bankers’ pay should be reformed and regulated going forward.

Although there is now wide recognition that bank executives’ decisions might have been distorted by the short-term focus of pay packages, we identify a separate and critical distortion that has received little attention. Because bank executives have been paid with shares in bank holding companies or options on such shares, and both banks and bank holding companies issued much debt to bondholders, executives’ payoffs have been tied to highly levered bets on the value of the capital that banks have. These highly levered structures gave executives powerful incentives to under-weight downside risks.

We show that current legislative and regulatory attempts to discourage bank executives from taking excessive risks fail to address this identified distortion. In particular, recently adopted requirements aimed at aligning the interests of executives tightly with those of the common shareholders of bank holding companies – through emphasizing awards of restricted shares in these companies and introducing “say on pay” votes by these shareholders – do not address this distortion. The common shareholders of bank holding companies, especially now that the value of their investment has decreased considerably, would favor different strategies than that would be in the interest of the government as preferred shareholder and guarantor of some of the bank’s obligations.

Finally, having identified the problems with current legislative and regulatory attempts, we analyze how best to implement recent legislative mandates that require banks receiving TARP funding to eliminate incentives to take excessive risks. Beyond banks receiving governmental support, we argue that monitoring and regulating the structure of executive pay in banks – along the lines we suggest – should be an important element of banking regulation in general, and we analyze how banking regulators should monitor and regulate bankers’ pay.

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Here is some more detail about what the paper does:

Much attention is now focused on the fact that pay arrangements have provided executives with incentives to focus on short-term results. They have enabled executives to take money off the table before it turned out that gains to earnings and stock prices were in fact illusory. This problem was first highlighted several years ago in a book and accompanying articles co-authored by one of us, and has recently become widely recognized. There is no question that short-termism could have contributed to excessive risk-taking, and a contemporaneous paper co-authored by one of us with Jesse Fried shows how compensation arrangements can be best designed to eliminate the potential distortions from such short-termism. But we identify in this paper some other key features or current and past pay arrangements that would lead to excessive risk-taking even in a world with one period in which there are naturally no problems related to the length of executives’ horizon.

We begin our analysis by describing the incentives of banks’ top executives in the run-up to the current crisis. The analysis of banks’ financing structure and compensation arrangements shows that bank managers’ incentives arose from an extremely levered bet on banks’ assets. Because top bank executives were paid with shares of a bank holding company or options on such shares, and both banks and bank holding companies obtained capital from debt-holders, executives faced asymmetric payoffs, expecting to benefit more from large gains than to lose from large losses of a similar magnitude. Transforming deposits into loans, banks are inherently levered institutions. But the standard structure of large banks – which are generally owned by bank holding companies and pay their executives partly with stock options – have added two additional layers of leverage. We illustrate the common capital and incentive structures of modern banks with numbers from Citigroup and Bank of America.

Our basic argument can be seen in a simple example. A bank has $100 of assets financed by $90 of deposits and $10 of capital, of which $4 are debt and $6 are equity; the bank’s equity is in turn held by a bank holding company, which is financed by $2 of debt and $4 of equity and has no other assets; and the bank manager is compensated with some shares in the bank holding company. On the downside, limited liability protects the manager from the consequences of any losses beyond $4. By contrast, the benefits to the manager from gains on the upside are unlimited. If the manager does not own stock in the holding company but rather options on its stock, the incentives are even more skewed. For example, if the exercise price of the option is equal to the current stock price, and the manager makes a negative-expected-value bet, the manager may have a great deal to gain if the bet turns out well and little to lose if the bet turns out poorly.

In the next part of the paper, we show that the crisis has not alleviated the problem that executive compensation currently provides managers with incentives enhance the value of common shares of bank holding companies or even option on the value of such shares even when such enhancement does not serve the interests of bondholders, depositors, and the government as guarantor of deposits. For some banks, the crisis might have made the divergence of interest between the interests of executives and the aggregate interests of those with a stake in the bank by reducing the value of executives’ shares, and options to buy shares, in the banks’ holding companies. Such reductions make executives’ payoffs all the more asymmetric. In the current circumstances, such divergence might lead the executives to avoid raising additional capital even when doing so is desirable to strengthen the cushion available to bondholders and depositors and to take advantage of ending opportunities.

We then assess against this background the measures adopted by Congress and proposed by the Treasury to regulate executive pay in banks receiving TARP funds. The main measures – the use of restricted stock in incentive pay and say-on-pay advisory shareholder votes on compensation – attempt to tighten the alignment of executives’ and shareholders’ interests. Our analysis of the divergence of interest between shareholders and contributors of capital to the bank that are senior to the shareholders indicates that this strategy could well be counterproductive. For the shareholders’ interests could well be served by taking risks that would be detrimental to the government’s interests as preferred shareholder and guarantor of some or all of the banks’ debt. The government has injected large amounts of money into the banks and in return has received preferred stock and other positions that are senior to equity. Moreover, the government guarantees deposits de jure up to $250,000 and might de facto have, or elect to shoulder, responsibility for deposits beyond this limit and other bank obligations. These interests of the government would not be well served by strengthening the link between executives’ interests and those of the shareholders of bank holding companies.

Finally, in the paper’s last part, we put forward better ways to regulate executive compensation in banks receiving TARP funds. More generally, we suggest that executive pay can be an important lever for banking regulation beyond both TARP recipients and the current crisis.

Moral hazard is inherent to banking, at least in the presence of deposit insurance. In principle, banking regulators are keenly aware of the problem and attempt to mitigate it by directly regulating banks’ activities. But given the complexities of modern finance and the limited information and resources of regulators, such regulation is necessarily imperfect. Moreover, as long as management’s incentives are tied to those of shareholders, management might have an incentive to increase risks beyond what is intended or assumed by the regulators, who might often be one step behind banks’ executives. Regulators should attempt to make management incentives work for, rather than against, the goals of banking regulation.

In addition to regulating banks’ behavior directly, the government could regulate the pay packages that shape how bank executives choose from the menu of actions allowed by this direct regulation. Such regulation of pay should focus on the structure of compensation – not the amount – with the aim of discouraging the taking of excessive risks. In terms of substance, to the extent that executive pay is tied to the value of specified securities, it should be based on a broader basket of securities and not only common shares. Rather than tying executive pay to a specified percentage of the value of the common shares of the bank holding company, it could be tied to a specified percentage of the aggregate value of the common shares, the preferred shares, and the bonds issued by either the bank holding company or the bank. Similarly, to the extent that executives receive bonus compensation based on accounting measures, such bonuses should not be based on metrics that reflect the interests of common shareholders, such as earnings per share, but rather on broader metrics that reflects also the interests of preferred shareholders, bondholders, and the government as guarantor of deposits. Such changes in compensation structures would induce executives to take into account the effects of their decisions on preferred shareholders, bondholders, and depositors and thereby would curtail incentives to take excessive risks.

The proposed regulation of bankers’ pay could nicely supplement and reinforce the traditional, direct regulation of banks’ activities. Indeed, if pay arrangements are designed to discourage excessive risk-taking, direct regulation of activities could be less tight than it should otherwise be. Conversely, as long as banks’ executive pay arrangements are unconstrained, regulators should be more strict in their monitoring and direct regulation of banks’ activities. At the minimum, bank regulators should closely monitor the structure of banks’ pay arrangements and take the incentives they generate into account when assessing the risks posed by any given bank and deciding how strictly to monitor and directly regulate the bank’s activities.